The recipe for growth

The recipe for growth is well-known. Most economists would agree that lower taxes and less regulation can encourage entrepreneurship and job creation. Yet, many governments are unwilling to introduce such reforms. An important reason is concern over a voter backlash. Jean-Claude Juncker, a likely candidate for the EU-presidency after two decades as Luxemburg’s Prime Minister, famously lamented

“We all know what to do, we just don’t know how to get re-elected after we’ve done it.” Based on an analysis of 109 governments in developed countries, we would suggest that Juncker’s view is mistakenly gloomy. Although market-oriented reforms may initially meet fierce resistance, governments that introduce them are more often than not rewarded by voters.

In our new book “Renaissance for Reforms” we look at the pace and direction of reforms in 29 OECD governments between the mid-1990s and the end of 2012. We base our analysis on the Heritage and Wall Street Journal Index of Economic Freedom, which annually ranks nations according to parameters such as freedom from corruption, freedom for investments and respect for property rights. We ask two simple questions: How did the level of economic freedom in these countries actually change according to the Index of Economic Freedom? And were the governments that reformed more often re-elected or not?

After controlling for the levels of unemployment during the year of election and the year of possible re-election, we examine if these factors are related. In contrast to Juncker’s views, we find that the government that increased economic freedom most were also most likely to become re-elected. Perhaps even more surprising is that this trend is driven by governments on the left.

Center-right governments that were re-elected increased economic freedom only marginally more on average compared to center-right parties that lost re-election. Governing parties on the left, which lost their bid for re-election, constitute the least reform-oriented group. Left governments that won however increased economic freedom at a 60 percent higher pace than the average center-right governments.

For example, during Tony Blair’s first term from 1997 to 2001 the economic freedom score in the UK increased by 1.2 points. True to Tony Blair’s reputation as a champion of New Labour’s moderate policies, the economic freedom score of the country increased by 1.6 points during his second term. Based on this track-record, Labour managed to win a third election, during which Blair handed over power to his more left-leaning rival Gordon Brown. As the leadership changed, so did the direction of reform. Between 2005 and 2010 the United Kingdom’s economic freedom fell by 2.7 points. The next election was won by the conservatives.

A commonly held view is that parties on the right introduce market reforms in order to boost growth, whilst those on the left mainly reduce economic freedom and aim to spread the wealth through welfare systems. In fact, countries that have successfully increased their levels of competitiveness have seen both sides of politics pulling in the same direction. Bob Hawke, former leader of the Australian Labor Party led his party to four consecutive victories in 1983, 1984, 1987 and 1990 based on wide ranking economic liberalizations. Paul Keating, the reformist treasurer under Hawke, took over party leadership and won a fifth victory in 1993, in an election initially thought to be unwinnable for Labor. Since then both conservative and left governments in Australia have continued on the path of market reform. The end result is more than two decades of consecutive growth.

Similarly, Canada was in very bad shape when Paul Martin, minister of finance in the newly elected left-liberal government, took office in 1993. The government made the difficult choice of market reforms, focusing on reduced spending through action such as abolishing transport subsidies for farmers as well as market liberalizations and lower taxation. Many interest groups objected to the changes. And yet, the Canadian Liberal party won a second term in 1997. The party campaigned on the promise to continue to cut the federal deficit, thereby creating a budget surplus which would allow tax cuts as well as repayment of Canada’s national debt. After another term of reformist policies, the liberals managed to win the elections again in 2000. In 2003 Paul Martin took over the reins and won yet another re-election. Conservative governments have since built upon the same policies, transforming Canada into North America’s new free market role model.

Why is it that governments on the left in particular can be rewarded by introducing market reforms? One explanation might be that this attracts centrist or even right-wing voters to the left. Another is that leftist government can couple market reforms with social features. A research survey by the OECD observes that when markets are opened up, competition often leads to higher employment. This tends to increase income equality, since those who would otherwise not work, or work only part-time, will raise their income. The same reforms can also help those with high productivity to raise their income compared to others, which instead will lead to higher income inequality. Hence, market liberalizations can lead to lower or higher equality, depending on which of these two factors come to dominate. There are good reasons to combine market oriented reforms with policies that strengthen the less well-off in society, such as strengthening publicly funded school programs.

Today many governments are wary of reforms. Change is seen as unwanted in the short term, and politically difficult to implement. This can explain why some governments in particularly Southern Europe are stuck on a path to failure. A common view is that “Juncker’s curse” will doom governments that are bold enough to change the status quo by cutting government handouts or liberalizing the economy. Our analysis of recent history shows that this impression is mistaken. Change is anything but easy to introduce, but can prove popular in the long term by boosting growth and employment. Of course, policies must always be adjusted to the particular needs of each individual country. The Kyrgyz Republic is today the 85th freest economy in the world. Sind the end of the 1990s the country has made considerable improvements in amongst others monetary freedom, trade freedom and investment freedom. However, much still remains to be done when it comes to areas such as protection of private property and freedom from corruption. If these areas are addressed with bold reforms, the Kyrgyz Republic could be on the path of strong growth. By strengthening market economic institutions greater wealth and job opportunities can be created for the broad public, whilst funds are generated for social programs. Such institutional changes will take time and political will to introduce. But once in place, they can influence long term competitiveness and prosperity.

Nima Sanandaji, PhD at the Royal Institute of Technology and policy analyst.

Stefan Fölster, Professor of economics at the Royal Institute of Technology, and director of the Reform Institute.

The authors have written the new book ”Renaissance for Reforms” which is co-published by Timbro and the Institute of Economic Affairs.